High cost of insider trading

Insider share trading and the detrimental effect it may be having on London's standing in the investment world is investigated by Ian Lyall.

City of London: Is its reputation at risk?

The City is awash with price-sensitive information. In particular, insiders seem incapable of keeping a lid on merger and acquisition activity.

It oozes out via the bankers, legal eagles and public relations advisors, and even board members.

So widespread is the abuse that the Financial Services Authority is waking up to the fact that there is a major problem, especially as it now threatens to undermine the reputation of the City of London as a major centre for world finance.

This is why Margaret Cole, the FSA's director of enforcement, has stepped up attempts to track down and prosecute the illegal share traders.

However, taking over the role of policing insider trading in 2001, the FSA has brought just five successful criminal prosecutions. Compare this with America, where the Department of Justice has been far more proactive and vigorous in taking on the share scammers.

The US stock market is far bigger than the LSE, and the American justice system in general has a peculiarly high conviction rate, but even allowing for this, the FSA's efforts have not been as successful as those of the American regulatory authorities.

Take another element: the fines meted out for insider dealing. This will tell you all you need to know about how seriously the issue is taken in the US.

In America the largest penalty ever imposed was on Joseph Nacchio, the former chief executive of communications group Qwest, who was fined a whopping $19m for insider dealing and made to forfeit the $52m he had illicitly gained.

He was also given a six-year prison sentence. In the UK, the biggest fine ever levied is… £750,000. Figures contained in the FSA's own annual report reveal a quite shocking statistic. Suspicious share price movements precede almost one-third of takeovers in Britain.

The FSA Annual Report 2009/2010 reveals how frequently share prices spike just before the revelation of a major piece of M&A (merger and acquisition) news.

The lowest level of suspicious share trading activity in the FSA study was 2003, with only (relatively speaking) 14% being classified as abnormal. Yet a year later the series hits a high point of over 32%.

The FSA cautions against taking all abnormal trades as indicative of insider dealing. They are not. It cites a number of reasons in its 2008/2009 annual report.

It points out the share price may have moved 'due to circumstances such as financial analysts and the media correctly assessing which companies are likely takeover targets'.

The second reason cited for the sieve-like nature of the London market is deliberate, strategic leaks of information by a company to position a deal in the marketplace.

I have to concur this does happen, with advisors and management playing fast and loose with market sensitive information in order to get a head start on the opposition in what is likely to be a long and protracted bid battle.

Finally, the FSA says a proportion of suspicious trades are made by 'informed traders who picked up on and derived information from insiders' trades'. How is this not insider dealing?

All traders know they are immediately at a disadvantage when a handful of connected individuals are privy to the intimate details of a bid, share sale or profit warning, and trade on that information.

If insider trading is allowed to fester and grow, then it will undermine confidence in the market (not to mention the market's efficiency) and it will damage the reputation of companies themselves.

There is also evidence that the prevalence of insider trading has a direct effect on the cost of companies raising equity.

John C. Coffee, a Professor of Law at New York's Columbia University, believes it can be significantly more expensive to raise capital in Britain, where light touch regulation has gone too far, than in the US where the rules of the market are far more strict.

Let me put it another way: If a firm opts for a dual-listing in the UK and US, Coffee believes that the reassurance provided by an American stock market quote will add around 37% to the value of the company compared to what it would have been if the owners decided merely to list in London.

Why? Because investors trust the highly-regulated US market - and the premium reflects that trust.

Coffee, in his December 2007 article on the subject, says: 'To explain the valuation premium that is associated with a US listing and conspicuously absent from a London listing, one is compelled to assign at least considerable weight to the variable of enforcement.

'Here the disparity is large. Indeed, simply the failure of the United Kingdom to effectively enforce its own insider trading restrictions... could alone plausibly account for a significant portion of this difference.'

• Ian Lyall's book The Street-Smart Trader goes on sale on January 10. Order from the Global Investor Bookshop at http://books.globalinvestor.com/books/289014/Ian-Lyall/The-Street-Smart-Trader